Challenges in Europe await Merkel after resounding victory

German Chancellor Merkel smiles during news conference after CDU party board meeting in Berlin

German Chancellor and leader of the Christian Democratic Union ( CDU) Angela Merkel, smiles during a news conference after a CDU party board meeting in Berlin September 23, 2013, the day after the general election. Merkel faces the daunting prospect of persuading her centre-left rivals to keep her in power after her conservatives notched up their best election result in more than two decades but fell short of an absolute majority. REUTERS/Fabrizio Bensch

By Luke Baker and Paul Taylor

BRUSSELS/PARIS (Reuters) - Once Angela Merkel has savored her third and biggest general election victory, the small issue of Europe awaits.

The poll result leaves the conservative German chancellor triumphant but still needing a coalition partner from among her centre-left rivals. The way forward for the European Union raises even trickier challenges.

From the likelihood of more debt relief for Greece, to more aid for Portugal, Spain's dangerously shaky economy, Italy's political instability and France's resistance to far-reaching reforms, the landscape is dotted with pitfalls.

Sunday's election result may have reinforced Merkel's central role in holding the continent together.

But rather than leading from behind, as aides describe her preferred approach, she faces pressure to assert more pro-active leadership if the euro zone is to sustain a recovery and take hard decisions needed to complete a banking union and underpin the currency union.

British officials believe Merkel also holds the key to Prime Minister David Cameron's bid to negotiate a return of some EU powers to national capitals, before he puts continued British membership of the Union to a referendum in 2017.

WISH LIST

France's industry minister, Arnaud Montebourg, a frequent critic of Merkel, wasted no time in laying out southern Europe's wish list and calling on the chancellor to step forward.

"Our common duty is to push Europe in a new direction, to ensure that this region - which is the only region in the world in recession - becomes a growth area once again," he told France's Itele news.

Merkel could start by implementing a minimum wage that would improve conditions for many low-paid German workers, boost domestic demand and help balance out its trade surplus, the French socialist said.

His cabinet colleague, Finance Minister Pierre Moscovici, said Paris also sought "more ambitious integration including completion of certain projects such as a banking union".

Diplomats said Germany, which has voiced alarm at France's economic weakness and told Paris it cannot carry the euro zone on its own, is pressing for more EU control over national budget policies and economic reforms in countries under EU disciplinary procedures, including France.

Days before the election, Merkel's office sent Paris proposals for euro zone states to sign binding "competitiveness contracts" committing to reforms of pensions, labor markets and welfare systems, enforceable in the European Court of Justice.

The French hate the idea, which would further erode national economic sovereignty, and are hoping other states will join in resisting it or watering it down, the diplomats said.

It may take Merkel two months to form a governing coalition before she can turn her attention fully to Europe.

Brussels officials have all but written off the chances of progress at the next EU summit in late October, putting back key decisions on the future of the euro zone till mid-December.

Politicians and analysts in southern Europe voiced hopes for a "grand coalition" in which the centre-left Social Democrats (SPD), who finished second in the poll, would soften Merkel's austerity policies and support economic stimulus measures.

"The government is hoping for a less punitive and more supportive approach towards Greece," said Theodore Couloumbis of the Athens-based ELIAMEP think tank.

"There are two types of teachers for pupils whose performance is not up to standard: those who emphasize sanctions and threats versus those who emphasize support and reward. The government is hoping for a shift towards the second - not only for Greece but for most countries in the European south."

SCRUTINY

The so-called program countries that have received financial assistance from the euro zone and the International Monetary Fund are no longer the biggest concern.

There is a quiet acknowledgement that a solution will have to be found in time to ease Greece's debt burden again, and that Portugal may well need further funds in the coming months before it can return to market funding.

Because those countries are strictly scrutinized by the 'troika' of the European Central Bank, the European Commission and the IMF, pressure can quickly be brought to bear if they veer off course.

The bigger concern is countries where there is no troika oversight but where problems could easily emerge, such as the collapse of the government in Italy or investors suddenly losing confidence in France's faltering commitment to economic reforms.

Italian Prime Minister Enrico Letta made clear his relief at Merkel's victory, as well as the narrow failure of Germany's new anti-euro AfD party to achieve a breakthrough, which might have spurred other eurosceptics, such as Italy's 5-Star movement.

"It's an important result for Europe," Letta told Italian TV. "It's very important that the anti-euro party stayed out of parliament. I think this is a good signal, a sign of the Europeanism of Germany."

Letta will also be hoping for support from Merkel's new government to tread a careful line between restive factions on the left and troubled ex-prime minister Silvio Berlusconi on the right, and avert a potentially debilitating political crisis.

"Merkel is so strong that she ate her allies, got indigestion, and will now be forced to forge new alliances, and we hope this will make her more wise and malleable," Maurizio Gasparri, a Berlusconi loyalist and deputy speaker of the Senate, said in a radio interview. "Her policies have made Germany great in Europe, but have weakened the other nations."

CLARITY

Europe's leaders are looking to Merkel for clarity on plans to establish a single framework for all the bloc's banks, and what steps she is willing to take to strengthen monetary union.

Both steps potentially require German taxpayers to take on more liability for other euro zone countries' debts and banks - moves regarded with deep suspicion in Germany.

The signs are that Germany is ready to push ahead with a less comprehensive form of banking union than proposed by the executive European Commission, avoiding changing the EU's treaty while keeping its own politically sensitive savings banks under national supervision.

This may raise concerns in financial markets and weaken the Commission, which will in any case change in November next year, after European Parliament elections in May.

In that respect Germany may be entering into a period of more intense "inter-governmentalism" - working directly with key national capitals rather than via the EU executive.

Britain, however, may well use it as the right moment to launch its offensive to renegotiate its ties to the EU.

Cameron values his close relationship with Merkel, who is keen to keep Britain in the EU both for its attachment to free trade and economic competitiveness, and to balance out the influence of statist French economic policy.

The German leader faces a tricky task of keeping Britain onside without letting it brake closer euro zone integration or turn the EU into a free-for-all where everyone can "cherry pick" terms of membership.

"Merkel is by far the best bet for Cameron, but the risk is that the British gamble on Merkel is based on an overestimation of their clout in Berlin," said a European diplomat in London.

"For Merkel, the European Union comes before Britain, however much she would like to keep Britain in."

Sovereign at home, Merkel also ranks highly in opinion polls in many other EU member states.

The next four years will determine whether she can to step out of the domestic fray and be a leader for all of Europe, not from behind, but from the front. And do it in such a way that it does not destabilize the post-war balance with France.

(Additional reporting by Nick Vinocur and Brian Love in Paris, Naomi O'Leary in Rome, Guy Faulconbridge and William Schomberg in London; editing by Philippa Fletcher)